Warning Signs from Small- and Mid-Caps

Their underperformance bodes ill for the broader market. Plus, 2 ways to play their slide

While all eyes lately have been on the Fed or across the pond on the European Central Bank, I find that the charts give me the most reliable signals. The most important one to me currently is the Russell 2,000 via its exchange-traded fund, the iShares Russell 2,000 Index ETF (NYSE:IWM).

The IWM closed below all of the daily key moving averages, including the 200-day exponential moving average (EMA), and looks to have formed a very large Bearish Symmetrical Continuation Pattern, which is one of the more well-known patterns that form in bearish trends.

Click to EnlargeYou can also see that the daily chart here is in a “1-2-3 Bearish Trend Reversal” on the daily. I’ve noted the trend in the lower chart, at the spot labeled “Bear.”

As far as the significance of this latest move down, it stands out because of the “aggressive” nature in the selling as well as the underperformance.

Recently, the IWM dropped 1.65% in a single day, while some of the other senior averages pulled back substantially less. Losses were between 0.29% on the S&P 500, 0.25% for the Dow Jones Industrials and 0.66% for the Nasdaq.

Click to EnlargeNow, let’s compare the S&P 600, the S&P Small-Cap Index (SML), which is made up of 600 small-cap stocks versus the IWM’s 2,000 stocks. Like the IWM, the SML also closed below all major moving averages, has underperformed the other senior averages all year and is in a “1-2-3 Bearish Trend Reversal” in all time frames. In addition, it now sports a Bearish Symmetrical Continuation Pattern and continues to decline on higher and higher volume, showing clear signs of distribution.

Additionally, the S&P 400, the S&P Mid-Cap Index (MID), isn’t doing much better. Like both the S&P 600 index chart and the IWM chart show, the MID has also underperformed the other senior averages all year and is in a “1-2-3 Bearish Trend Reversal” in all time frames. And, yep, you guessed it: It now sports a Bearish Symmetrical Continuation Pattern and continues to decline on higher and higher volume, showing clear signs of distribution.

Click to EnlargeConclusion: According to academic research, when small- and mid-caps start underperforming relative to their larger-cap counterparts over time and the underperformance begins to accelerate to the levels we’re seeing now, a significant event (good news in bullish markets, or bad news in bearish markets) is very close at hand.

History tells us that when it comes to bull and bear markets, the small- and mid-caps are what have historically “front run” major tops and bottoms as they outperformed or underperformed at specific cycles within the cycle of each bull and bear market. Whether it was cyclical or secular, bull or bear happened to be irrelevant. So, we’re seeing clear warning signs like we did in 2007-2008 that something sinister is lurking.

There are a couple of different ways to play the slide in these small- and mid-cap stocks as we wait for the impending drop.

1.You can go after individual names headed for a tumble. Right now, one of the “small dogs” on my lists is Chart Industries (NASDAQ:GTLS). You can buy the GTLS Sept 55 Puts around $2 for a chance to more than double your money, as I see the puts going to $5.

2.You can go after the whole index as it falls off a cliff. As I noted above, the IWM is the most important chart I’m watching right now, and there are plenty of put options to pick from. I like the IWM Sept 22 Expiration 71 Puts (the regular “monthly” puts, not the more expensive quarterly puts). You can pay up to around $1 for them, and, here again, I think you can get more than twice your money with a profit target of $2.50 in the puts.

Regardless of how you play it, take note of how weak the small- and mid-caps are because I expect the rest of the market to follow suit.